The U.S. economy has surprised many with its resiliency, despite aggressive rate hikes by the Fed. Alex Gorewicz, Portfolio Manager, Active Fixed Income at TD Asset Management, looks at whether recent data may suggest signs of economic softness are emerging.
Greg Bonnell: The economy is showing some signs of slowing as central banks continue to keep rates at elevated levels. But are we at a potential turning point for borrowing costs and the bond market?
Joining us now to discuss, Alex Gorewicz, Portfolio Manager for Active Fixed Income at TD Asset Management. Alex, always a pleasure to have you back here.
Alex Gorewicz: Thanks, Greg. Good to be here.
Greg Bonnell: So let’s talk about the big question on everybody’s mind. Every day, some sort of economic data point comes out, whether it’s here at home or south of the border, we read the tea leaves. What are we seeing lately?
Alex Gorewicz: Maybe looking back so far on the third quarter — and we still have a month to go — more resilience than anticipated across a number of economic indicators, particularly around labor, and then how that’s been feeding into better-than-expected retail spending, personal spending, and then, therefore, given how much consumption contributes to GDP, better-than-expected GDP performance, particularly in the US, maybe more in line in Canada.
And these have been feeding into a concern by some investors — probably by more investors — that perhaps core inflation, which is really driven by wage growth, by more labor-oriented indicators, will remain stickier and will be really hard-pressed to come down to 2%, which is where the Fed and Bank of Canada are targeting inflation in the medium term.
That’s leading others to say, perhaps monetary policy is not restrictive enough. And I think that’s been playing into very volatile bond market through the summer.
Greg Bonnell: Yeah, for the past couple of weeks, and with all of those factors playing out, we did see yields continuing to push higher in the bond market. In the past couple of days — and it’s only a couple reports, but it did feel like perhaps there’s some indication — I’m thinking of the private payrolls south of the border. There was an addition of jobs, but not as firm as expected, apparently. When workers change jobs in the States now, they’re not getting the big raises they were getting before. Are we seeing any other signs like that, where someone who’s on the other side is saying, well, when are they going to be done, maybe some indication that the work is starting to work?
Alex Gorewicz: Yeah, so that’s where you have to get into the underlying details and say, well, perhaps monetary policy is restrictive enough, when you realize that labor indicators are usually the last shoe to drop. And although it’s very early, to your point, you’ve started to see a couple of indicators suggesting there is a softening in the picture — for example, Challenger job cuts came through quite substantially for August.
You’ve seen a reversal from pretty impressive beats in initial jobless claims in July. You’ve seen a bit of a reversal of that in August. Job openings were weaker than expected. ADP numbers were a bit softer. And how that all plays out in tomorrow’s non-farm payrolls number in the US remains to be seen — but a bit of a mixed picture when you look at the underlying details. And again, the job market is sort of the last shoe to drop.
But something that is absolutely of note, suggesting monetary policy is tight and is having the intended effect, is looking at commercial bankruptcy filings. Businesses are starting to crumble at the weight of higher interest rates. But it’s not the ones in the S&P 500. It’s not the mega-cap companies that we’re all tracking and that we’re all paying attention to. It’s a lot of the smaller and medium-sized businesses.
And unfortunately, those are the ones that contributed to the majority of job growth coming into this year. So if you extrapolate that forward and that pain in that segment of the economy or in that segment of companies continues because of where monetary policy is, it suggests that we could see a lot more softening of labor market, and in a more visible way, in the next several months.
Greg Bonnell: Now, by the Central Bank’s own metrics and admissions, they are in restrictive territory already. The bond market’s been interesting this summer. If we’re going to talk about what is a fair value of rates right now, do we have any even idea if someone would say, oh, the 10-year is at this, and now the 10-year is at that? I’m like, should it be there?
Alex Gorewicz: I don’t think that fair value is even a consideration in terms of where bond yields are. I mean, they’ve been screening as being really cheap. In other words, yields are too high relative to where some of the fundamental data points that historically have been explanatory factors for interest rates. That discrepancy is so wide right now.
What the bond market has been paying attention to has been, really, initial jobless claims because that’s sort of the most timely indicator of the labor market. And again, that’s sort of the last shoe to drop in terms of a monetary policy cycle.
But in thinking through where the fundamentals should be, what’s been very notable in this more recent backup in interest rates through the summer has been a repricing of long-term policy rate expectations. That’s very positively correlated with this notion of R-star. So I’m sure you’ve heard us talk about that before, me and my colleagues. What that really means is the longer-term interest rate that’s compatible with an economy in equilibrium.
And at Jackson Hole, Chair Powell kind of alluded to the fact that R-star has been indicated as being higher by certain market observers, but that they still don’t feel that they’re confident enough in that assessment. In other words, the Fed’s not really buying this notion that somehow interest rates should be higher for longer in the long run.
It’s also very interesting, and perhaps contradictory, that the prevailing narrative in the market is, oh, you know, a resilient labor force, meaning wage growth will be sticky, and that will push core inflation higher in the long run. When you look at how interest rates have risen in the last couple of months, it hasn’t been inflation expectations that have been driving that move higher. It’s actually been real rates that have been driving that move higher.
So again, not really — the narrative and the reality are sort of not compatible at this time. So it’s really difficult to say where should the fair value of interest rates be and is the market trading based on those factors.
Greg Bonnell: When you were saying that, it made me think of some data points I saw a couple weeks ago, with the fact that we hear about the resilient consumer, the resilient consumer, and the south of the border credit card debt — I think it got above $1 trillion for the first time. People were apparently tapping into their — what are they? They call them 401(k)s south of the border — their retirement money. That doesn’t speak to me of a consumer with extra money to spend. This points to me to households looking, where am I going to find the money that I need to get through the month?
Alex Gorewicz: Correct. And we’ve anticipated, and we have seen this come through, that excess savings that were built up during the pandemic would be depleted. And that’s still on track to happen. And you’re starting to see it in ways like drawing on available sources of credit.
But even from a financial market perspective, I think it’s noteworthy that if you look at leverage and margin accounts, they’re rising at a point where monetary policy is, by its own assessment and by many people’s assessment, already in restrictive territory. Those are the kinds of things that give you some reasons to question the sustainability of this more risk-on or optimistic turn in markets during the summer.